Going into Business For Yourself
Buying an existing business:
Should you consider it?
If dreaming is as easy as falling asleep, why should fulfilling your dream be any more difficult, especially when it comes to owning a business? Why not buy one already in full swing? You can step into an operation with a reputation, cash flow and customers.
Most wanna-be entrepreneurs do end up weighing the advantages of buying a business vs. baking one from scratch. Perhaps they have accumulated some cash and no longer wish to work for someone else. Maybe they have the experience and skills to run a small business, but no desire to start it from the ground up.
The Small Business Administration estimates that nearly one-third of all independently owned, non-franchised business startups are discontinued within their first year of operation and two-thirds are shut down within the first five. Makes an established firm with a solid history look pretty good.
But buying a business has its share of tedious legwork and planning, too. You may not have to find a location or customers, but you do have to make sure the business is in the right area and thriving.
What to consider
There are several key elements to consider when looking at a business for sale, both tangible and intangible. But the first question you want answered is "Why?" Why are the owners selling the business if it's the gold mine they profess it to be? There should be a good reason from the owners, anything from retirement to just plain boredom.
Take that answer and begin the detective work needed to evaluate the business. Look at everything and ask questions of everyone involved, not just the owner, but the competition, the local chamber of commerce, neighborhood programs, trade associations, suppliers and customers.
Of course, the seller may want the pending sale to be kept quiet, so make sure he's aware that you plan to approach outside sources. Best not to botch the deal before you've even begun to negotiate.
You can do much of the investigative labor, but eventually you will need the help of an accountant and an attorney familiar with the buying and selling of businesses. They can take an objective view, and help you analyze the significance of the information you
Buying an existing business: Assets and liabilities
Company assets will have the most impact on the overall value of an existing business. Assets can include cash, contracts, receivables, inventories, and physical property and equipment. Carefully examine the condition of the assets, as current market values may differ from the initial cost of items. Things like old receivables may become your bad debts and outdated equipment can be costly to replace.
Liabilities include mortgages, outstanding loans or liens, unpaid taxes and any other obligations, such as accounts payable to suppliers. If the property is included in the deal, what are the lease or mortgage terms? Review any accrued liabilities with extreme caution. Legal advice is worth the cost, especially if you agree to take on some of the liabilities. Are there any lawsuits pending? Make sure there are no ugly secrets ready to jump out and surprise you in the future.
Buying an existing business: Examining the financials
Before you make a commitment to buying a business, ask to see five years' worth of company financial statements. Your accountant can be of great help as you check these records. Many experts recommend auditing the books rather than accepting a set of financial statements prepared by the current owner.
Besides tax returns and sales reports, you'll want to examine profit-and-loss statements, cash-flow statements, inventory turnover, accounts receivables and operating budgets. The company's business practices and accounting methods should also be reviewed. Create your own profit projections using current market conditions and the financial information you gathered from the company.
When examining the financial statements, banks are known to use upwards of 150 financial ratios to examine the health of the business. So, for the most part, you will rely on your accountant to perform ratio analysis. You should at least learn, however, the definition of the current, quick, days payable, days receivable, inventory turnover, return of assets (ROA) and return on investment (ROI) ratios.
Current and quick ratios address the financial liquidity of the business. They reflect the ability to liquidate current assets to pay off current liabilities. We are not assuming you will need to liquidate if the business is solvent, but these ratios reflect how well you could meet unexpected expenses without compromising fixed assets. Days payable and days receivable also reflect liquidity, and tell you how long the seller normally takes to pay off accounts payable, and how long it takes the seller to collect on accounts receivable. Assuming this is not a "cash-only" business, 30 days is the ideal average for payables and receivables. The exception would be where early payment of a payable results in a discount to you.
For the product-based business, inventory turnover reflects the number of times the average inventory on hand is sold in a year. For example, an inventory ratio of 5.5 indicates the business sells its average inventory 5.5 times per year. The higher the ratio, the more times the product is sold, and the more sales you generate. You will need to compare the seller's performance with industry averages in order to arrive at assumptions about whether the business is prospering.
Return of assets and return on investment are performance ratios of investment. They demonstrate how well the seller is using business resources to generate profits. Return of assets shows how well company assets are used to generate profits. Return on investment shows how well capital investment is used to generate profits. As in all other ratio analysis, the seller's performance should be compared to industry performance.
The banking industry generates annual results of ratios for hundreds of industries, which are published in many different directories. Commercial lenders and many CPA firms have these publications, as well as many public libraries.
Ratio performance is divided into three categories: the upper quartile (25 percent), the middle half (50 percent), and the lower quartile (25 percent) of performers in each industry. Ideally, the seller's ratios would be in the upper quartile, if not the upper range of the middle (average) performers.
Importance of the marketplace
Whatever is happening in the local market will greatly affect the future of the business. If, for instance, you're buying a small boutique and a major mall is planned a few blocks away, you should reconsider.
And what about roadways? Even a simple change in traffic patterns can drive future customers right past your door. Small businesses sometimes fold if they are on a thoroughfare that remains under construction for an extended time. And the construction of the interstate highway system, closing down Route 66 across the country in the 1960s, exemplifies the decline of business due to rerouting of traffic.
Buying an existing business: Identifying the competition
You will need to discover whether the company has any competitive advantage and determine its current percentage of market share.
Unless the seller is operating in a national or international market, prepare to do some homework about the competition and the industry in general. Industry and trade associations usually do not take strictly local data into consideration when compiling market data, unless the association has a primarily local membership. For example, real estate associations maintain intense and accurate local data. But for the most part, industries will not readily supply local market data.
However, a little bit of effort, some coins for the photocopy machine and access to the Internet provide substantial data. The simplest source for looking up competitors is the Yellow Pages. Many local libraries maintain back issues of these telephone directories in hard copy and on microfiche.
When reviewing the data, count the number of competitors listed by year. Are their numbers growing? Are they growing or declining in any particular area of town? Who pays for larger advertising space? Is there more or less promotion from one year to the next? A five-year comparison should be sufficient.
A second major source of information is the "County Business Patterns" report, published annually by the Bureau of the Census. All businesses fall into one of 99 categories. You will find sales performance, number of businesses, number of businesses by size of work force, payroll and more. A third major source of competitor and industry performance information is the Economic Census Data published by the Bureau of the Census in the third and seventh years of each decade. The reports expand on the information of the yearly business patterns report, and include a detailed breakdown of categories and subcategories of industries. This information is generated on the state and national levels.
Finally, every state has a department charged with the responsibility to collect, report, audit and issue reports on the collection of that state's sales taxes. These state departments of revenue issue periodic reports on sales and tax collection performance by industry. Contact the nearest office of your state's sales tax collection agency to learn more about data available for public distribution. Economic data from the Bureau of the Census is available online or at most libraries. For more information on industry comparisons go to our chart.
Develop your competitive strategies after learning the competitive environment and discovering the focus on loyalty to the customers and the levels repeat business and good customer service.
If there is friendly competition, the seller may have a cooperative relationship with competitors, in which the businesses refer customers to each other if a product or service is not available where the customer first appears.
Quite often, this relationship exists where competitors can profitably co-exist. At the other extreme is a fiercely competitive market in which, perhaps, one business may engage in predatory pricing designed to steal away another's customers.
Buying an existing business: Ready-made customers
One major advantage to buying an existing business is the immediate stream of cash from customers. Customers can be considered among the assets of a business for sale, especially if there are contracts that can be transferred.
Will clients stay with you? In the case of a service-oriented business like a beauty salon or a financial planning office, maybe not. They may decide to follow the former owner or his employees. Under these circumstances, negotiate a non-compete clause with the owner and employees that covers a specified period.
But just who are these customers? For certain businesses, a brief description of the "typical" customer is a "no-brainer." For example, if you were going to buy a beauty salon in an economically upscale neighborhood, the typical customer would be a female from a higher-income household.
On the other hand, many different kinds of people walk into a hardware store. It doesn't matter how rich or poor a customer may be, the light bulbs do have to be replaced once in awhile.
In the product-related business, consider disguising yourself as a customer to browse the seller's store, and then peruse the nearby competitors. Compare products and prices. Casually observe the other customers. Make note of gender, age, what they buy and why. Is the purchase for work or home? Did the customer come alone or with friends, family or co-workers? (They do influence purchases).
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In the service business environment casual observation is difficult, so you will have to rely on the seller to give you a detailed description of the typical customer: gender, age, profession, habits and any other details that appear to be relevant. Industry and trade organizations provide the most logical alternative for gathering demographic data about the typical customer.
If the business proves to be profitable, you will want to keep the present customer base. The strategy you implement will be determined by the seller's historic relationship with his customers, how well the seller knows them, the seller's willingness to participate in the transition of ownership and the point in time when the employees are made aware of that transition.
Good customer service is the hallmark to repeat business and loyal customers.
If the seller has maintained good relations with the customers, you want him to participate in informing them of the new ownership. Create the opportunity to meet the customers in the presence of the seller, assuring them of your determination to maintain the same level of service. This also provides the opportunity to learn even more details about these people, and why they buy at that business.
Employees are the "front line" in customer service. You are only as good as your employees.
Timing is critical in successfully recruiting employee support. Employees are fearful of a change in ownership until they have the opportunity to meet you and assess whether they will have a future with the business. Once the terms of sale have been reached, immediately plan to meet with the employees in a group setting and then individually. Let them know who you are and give them the opportunity to learn more about what is to come.
Buying an existing business: The value of a reputation
Good will is the perceived image of a business and it can extend far into the community. It can also affect many key relationships, including those with bankers, suppliers and customers. A good image is invaluable; a negative image is almost irreversible. Make sure you know the company's reputation by asking questions around town.
Suppliers are a critical link in the process of ownership takeover. Even if the current owner has a good relationship with his suppliers, you will have to contact them to provide the details they need to establish a clear image of who you are and how reliable you will be in making payments.
Buying an existing business: Staffing considerations
Buying a business with a staff in place can help smooth the transition in ownership. You'll have to evaluate current employees to determine if they fit in with your vision, or even if they want to stay. Don't overlook the importance of employee relationships with customers.
The staff is your "front line" for maintaining good customer relations. You first must make sure you have sufficient people to perform all the tasks related to operating the business, that job descriptions are adequate, and that there is little or no duplication of work. Then make sure your budget and cash flow will cover the money needed for wages, salaries and benefits.
Next, perform the difficult task of assessing the business's employees. Does the employee fit in? Is he a team player? Does he intend to stay or seek employment elsewhere once you take over? This evaluation begins with the first group meeting and carries over to one-on-one meetings. You must be a good listener and observer. Your characteristics of leadership will be tested.
Don't forget to seek the seller's input on each employee, but don't rely exclusively on those observations. Furthermore, your visions and plans for the future of the business will likely differ from those of the seller. Don't be surprised if one or more employees leave.
Buying an existing business: Uncle Sam and the fine print
Check to make sure that all tax payments are current, including sales and unemployment tax. Payroll taxes are the first to slip when a company has cash flow problems. Any Internal Revenue Service audits in the past? If so, what was the outcome? Look at all patents, copyrights, trademarks or logos, and note the expiration dates.
Your state's department or division of sales tax revenue can confirm if sales tax payments are up to date. Your accountant's examination of financial and bank statements will determine if payroll and corporate income taxes are being paid on time. Corporate attorneys specializing in trademarks, patents and copyrights can conduct searches and examine business files to determine legitimacy, values and expiration dates.
Buying an existing business: What you should pay
How much should you pay for the business you want? Determining the worth of a business is difficult and involves a process called "valuation."
There are several types of valuation techniques, none of them is very simple, and none is considered a golden standard, according to Internal Revenue Service rules.
Your certified public accountant can direct you on the best method for valuing a business in your particular industry. The two most common approaches have to do with replacement of assets and return-on-investment.
Asset valuation
Sometimes called book value or balance sheet method, this process basically involves totaling the replacement value of the tangible assets. An outside appraiser usually does the work. Intangible assets may or may not be a part of the equation. Rely on the combined input of your accountant and attorney to properly appraise the value of intangible assets. Subtract liabilities from appraised assets to come up with a company's net worth and a base for negotiating fair price.
Income statement valuation
What will the rate of return be on your new investment? Surely you want it to be better than the one you can get in a money market fund, a federally insured certificate of deposit or even the stock market. Your main reason to invest in a business is to make a profit, so you need to compare the rate of return for this investment with that of others. Start by calculating the future earnings of the business based on historical data of cash flow and expenses.
Review the historical performance of the financial ratios and of the sales that appear on the income statement. Finally, review the trend of economic data in the County Business Patterns, Economic Census Data and the Yellow Pages. These will provide the basis for making assumptions about projected sales, net profit and returns on investment.
If there are any inconsistencies in the historic trends of the business, examine the footnotes to the financial statements. For example, long-term liabilities -- perhaps a real estate loan -- may have been paid off early, causing cash on hand and retained earnings to decline. This can dramatically reduce liquidity and earnings ratios. On the other hand, short-term liquidation of a sufficient amount of discontinued merchandise in inventory can dramatically increase cash on hand and the quick ratio, while the current ratio may decline.
So, what is it worth?
Having projected future earnings, you have to calculate the present value of those earnings by selecting your optimum return on investment. According to the Small Business Administration, the lower the risk associated with the investment, the lower the required rate of return, which can range between 20 percent and 50 percent.
If you divide the projected earnings by the return on investment, you'll come up with what's considered a fair price range. For example, if the asking price of the business is $140,000, and projected annual earnings are $26,000, then a fair price for someone seeking a 25 percent return on investment would be $104,000 ($26,000 divided by 0.25) and $130,000 for a 20 percent return. ($26,000 divided by 0.20)
But other factors also will come into play when determining a fair price, including the nature of the business, the economic condition of the industry, interest rates and the availability of financing. Of course, even after all those calculations, you can't overlook the true value of the business, or the bottom line of what the buyer is willing to pay the seller.
To find out more about how to value a business for sale or purchase, you can fill out an online order form for the SBA publication, "How to Buy or Sell a Business" (Publication MP16).
Buying an existing business: Financing the purchase
Financing options for the purchase of an existing business match those for starting a small business with one exception: seller financing. According to the Small Business Administration, the majority of owners with small businesses for sale offer financing. When considering money sources, the buyer should look first to the seller, then to personal equity and finally outside lenders.
When turning to an outside lender such as a bank or venture capital firm, the buyer must be able to pledge some type of collateral. Commercial lenders consider all fixed and some adequately appraised intangible assets are "fair game." You will not be allowed the full appraised value of those assets. The type and condition of the asset, in part, will determine its collateral value. Personal fixed assets are often pledged as collateral. Generally, real estate is the most preferred personal asset.
Venture capitalists are going to look for a greater return on investment ratio over a shorter period. In exchange for cash, they may want part ownership or to participate in setting the business's policies, procedures and operations. Granting partial ownership bypasses the need for collateral.
For the most part, your financial needs and credit rating, the market appeal of the seller's business and industry, and the related level of risk will determine whether you seek a more traditional, commercial loan, or entertain the idea of venture capital investment.